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How Does Social Security Work?

Posted by Noah Meyerson and Sheila Dacey on

September 19, 2013

The federal government spends more on Social Security than it does on any other single program. Created in 1935, the program has long consisted of two parts: Old-Age and Survivors Insurance (OASI), which pays benefits to retired workers and to their dependents and survivors, and Disability Insurance (DI), which makes payments to disabled workers who have not reached full retirement age (the age of eligibility for full retirement benefits) and to their dependents. In all, more than 57 million people currently receive Social Security benefits. CBO estimates that outlays for that program in fiscal year 2013 will total $809 billion, accounting for nearly a quarter of all federal spending.

During the program’s first four decades, spending for Social Security increased relative to the size of the economy, reaching about 4 percent of gross domestic product (GDP) in the mid-1970s. That increase was caused largely by repeated expansions of the program. Costs rose to 4.8 percent of GDP in 1983, the year that the last major piece of legislation focused on Social Security was enacted. Between 1984 and 2008, spending for Social Security fluctuated between 4.0 percent and 4.5 percent of GDP. During the most recent recession, GDP contracted and Social Security outlays increased more rapidly than they would have with stable economic growth because the number of OASI and DI claimants rose as the job market deteriorated. As a result, outlays grew from 4.1 percent of GDP in 2007 to 4.7 percent of GDP in 2009 (see the figure below). CBO anticipates that spending for Social Security will reach 4.9 percent of GDP in 2013, and if the full benefits specified under current law were paid, spending would reach 6.2 percent of GDP in 2038 and remain close to that value in subsequent decades (see The 2013 Long-Term Budget Outlook for more information).

How Social Security Works

Social Security is often characterized as a retirement program because a majority of its beneficiaries—70 percent—are retired workers or the spouses and children of those people. In general, workers qualify for retirement benefits if they are age 62 or older and have paid sufficient Social Security taxes for at least 10 years. However, Social Security also provides other types of benefits, such as payments to deceased workers’ survivors, who make up 11 percent of beneficiaries. In addition, workers younger than the full retirement age who have had to limit their employment because of a physical or mental disability can qualify for DI benefits, in many cases with a shorter employment history. Disabled workers and their spouses and children account for 19 percent of beneficiaries. In dollar terms, retired workers and their dependents receive 68 percent of Social Security benefits, survivors receive 14 percent, and disabled workers and their spouses and children receive 18.

The benefits that retired or disabled workers initially receive are based on their individual earnings histories, although those earnings and the formula used to compute initial benefits are indexed to changes in average annual earnings for the workforce as a whole. In subsequent years, a cost-of-living adjustment is applied to the initial benefits to reflect annual growth in consumer prices.

Workers born before 1938 were able to receive full retirement benefits at the age of 65. But under a schedule put in place by the Social Security Amendments of 1983, the full retirement age increases gradually. It reached 66 for people born from calendar year 1943 to calendar year 1954; it will increase again gradually beginning with people born in 1955, who will turn 62 in 2017, and it will reach 67 for people born after 1959, who will turn 62 in 2022 or later. The age at which workers may start receiving reduced benefits remains 62.

The Social Security Administration estimates that workers who retire at age 65 in 2013 and who had earnings equal to the average earnings of all workers in the country throughout their career will qualify for an annual benefit of about $18,000. That amount will replace slightly more than 40 percent of their preretirement earnings. In coming decades, the replacement rate will be lower for workers with average earnings who retire at age 65, mainly because of the scheduled increase in the full retirement age. Nevertheless, because initial benefits are based on beneficiaries’ previous earnings indexed to overall average wages and because wages grow over time, the real (inflation-adjusted) value of those benefits will rise over time.

The Social Security program is funded by two sources of dedicated tax revenues. Roughly 96 percent of those revenues derive from a payroll tax—generally, 12.4 percent of earnings—that is split evenly between workers and their employers; self-employed people pay the entire tax. Only earnings up to a maximum annual amount ($113,700 in 2013) are subject to the payroll tax. That amount, referred to as the taxable maximum, generally increases each year at the same rate as average earnings in the United States. However, the share of economy-wide earnings that falls below the taxable maximum varies each year as the distribution of earnings changes. When earnings inequality increases, as it has in recent decades, the taxable share of earnings declines because a greater share of income is above the taxable maximum. Earnings inequality will grow somewhat during the next few decades, and the share of earnings subject to the payroll tax, which has varied between 82 percent and 85 percent in recent years, will average around 82 percent in coming decades, CBO projects.

The remaining share of tax revenues—4 percent—is collected from income taxes on benefits. Those filing singly must pay taxes on Social Security benefits if the sum of their non-Social Security income and half of their benefits exceeds $25,000. The threshold for those filing jointly is $32,000. Under current law, those thresholds remain fixed, with no adjustment for earnings growth or inflation.

Revenues from both sources are credited to the two Social Security trust funds (the OASI trust fund and the DI trust fund). Social Security benefits and the program’s administrative costs are paid from those funds; benefit payments constitute 99 percent of total outlays for the program. Interest on the trust funds’ balances is credited to those funds, but because the interest transactions represent payments from one part of the government (the general fund of the U.S. Treasury) to another (the Social Security trust funds), they do not affect federal budget deficits or surpluses. The balances in those funds ($2.8 trillion at the end of August 2013) have accumulated over many years, during which tax revenues and interest received by the trust funds have exceeded the benefits paid from those funds.

In 2010, however, for the first time since the enactment of the Social Security Amendments of 1983, annual outlays for the program exceeded annual revenues excluding interest credited to the trust funds. A gap between those amounts has persisted since then, and by CBO’s projections based on current law, outlays would exceed such revenues by around 13 percent over the next decade. After that, the difference would grow; by 2038, outlays would be about one-third greater than annual revenues excluding interest credited to the trust funds. CBO projects that, under current law, the two Social Security trust funds combined would be exhausted in calendar year 2031. Once the trust funds are depleted, the Social Security Administration would no longer have legal authority to pay full benefits when they are due.